Could Regulation Spur Innovation?

The financial sector is going to become more heavily regulated soon. Last week, the Treasury department unveiled a new framework for regulatory reform. The framework places special emphasis on firms deemed to be “systemically important.” This designation will account for firm’s size, their level of interdependence with other firms, and how important they are to lending, although metrics for none of these criteria have been announced.

The new regulations will seek to counter the instability created by new financial products like credit default swaps and collateralized debt obligations. Regulators will always seek to point out the cause of the current crisis for new rules. Yet the cause of this crisis is unlikely to be the cause of the next (see for instance the creation of the Office of Thrift Supervision following the Savings and Loan crisis).

In testimony before the House Financial Services Committee, Treasury Secretary Timothy Geither expressed conflicting thoughts on innovation. He first explained that innovation and complexity “overwhelmed the checks and balances in the [financial] system” but proposed that regulation recognize a role for future innovation.

The new rules must be simpler and more effectively enforced and produce a more stable system that protects consumers and investors, rewards innovation, is able to adapt and evolve with changes in the financial market.

Even if initiating a single financial regulator and expanding their scope clarifies rules, the new regime will still give businesses new conditions to play by. While the regulation is likely to lead to new compliance costs, it could also cause innovation. In fact, new financial instruments are often in response to regulation. For example, changes in benefit requirements by the Pension Benefit Guarantee Program, which insures defined benefit retirement plans, increased interest in defined contribution plans.

In fact the troubles at large firms like Citibank or AIG may free space for new firms to innovate. Long-standing work by the late Mancur Olson argued that political stability hindered economic growth. He looked at Europe following World War II and argued that its countries were able to grow quickly because new governments had weak relationships with business and little lobbying occurred. While the current crisis will do little to decrease lobbying, populist anger may reduce the efficacy of such work and free up space for smaller firms or new, as of yet unregulated, products.